are necessary to determine cost of goods sold and ending
inventory. Note the word "assumption". Companies make
certain assumptions about which goods are sold and which goods remain in inventory. This is for financial reporting and tax purposes only and does not have
to agree with the actual movement of goods. The only requirement is:The total cost of goods sold plus the cost of the goods remaining in ending
inventory for financial and tax purposes is equal to the actual cost of goods available.Cost flow assumptions are timing issues. I.e., over the life of the firm the total
cost of goods sold for financial reporting and tax purposes must be equal to the total
price paid for inventory.

This cost flow assumption is the exact opposite of the specific
identification method: All goods of a certain type are assumed to be interchageable
and the only difference is their purchase price. Price differences are due to
external factors (for example, inflation; a sudden cold spell affecting availability of
produce; an increase in the price of gasoline because OPEC reduces the amount of oil
pumped.Under the weighted average cost flow assumption all costs are added
and divided by the total number of units purchased. At the end of the accounting
period, the number of units sold (left in inventory) is then multiplied by the average
price per unit to determine cost of goods sold and ending inventory. Example

Under this cost flow assumption each time a sale is made, the
actual cost of the item is determined and charged as cost of goods sold. This is
primarily appropriate in the case of items that can be clearly differentiated, have high
value and sales low volume. E.g., custom built kitchen cabinets. Example

This cost flow assumption closely follows the actual flow of
goods. In other words, the items purchased first are assumed to have been sold
first. Goods purchased at the end of the accounting period remain in ending
inventory. This cost flow assumption is logically appealing, since it follows the
normal actual movement of goods. Example

This cost flow assumption was developed for tax purposes.
However, because of tax law requirements, if a company uses this assumption for tax
purposes it must also use it for its financial statements. It does not coincide with the actual movement of goods. LIFO
is used during inflationary times to defer income tax payments. Under LIFO the goods in
inventory at the beginning of the period is assumed to remain in the ending inventory
(perhaps for decades). Obviously, this does not actually happen! Remember, this is an assumption only. LIFO is a method to
defer taxes until the "beginning" inventory is sold (either because the company
changes to a different method or because it has not replenished its inventory of the
particular goods or class of goods). If this event occurs, the lower cost of goods
(based on costs incurred at a much earlier time) will result in higher income and
correspondingly higher income taxes. In other words, the taxes deferred during
earlier times will now become payable, assuming there have been no changes in tax
law/rates. LIFO requires significant record keeping and careful management of
purchases. It also results in significantly understated inventory values (assets) if
it has been used for a significant length of time and/or if there is significant
inflation. However, it results in significant tax savings (cashflow!). Example

Problems associated with LIFO (and solutions)

In addition to the record keeping requirements (and
resulting costs) mentioned above, a major potential problem is the possibility of
"involuntary LIFO liquidation" of inventory. This may result from unexpected
high sales volume at the end of the accounting period. One way to avoid this is to
carefully manage purchases. Another, popular, method is "inventory
parking". Under this approach an inventory purchase is made on paper, but
the inventory is not actually delivered. The "seller" agrees to repurchase
the goods at a slightly higher price after the financial statement date. This is
considered acceptable for tax purposes, but not for financial accounting.

A second cause of involuntary LIFO liquidation is a
change in the inventory mix. (If tastes change, there is no point in maintaining an
inventory of record players, if the market demands CD players, for example). Two
solutions exist for this problem: